Financial Stability Report for October 2004

Forward

This is the first of a series of reports that the Reserve Bank will be publishing every six months on the New Zealand financial system.

The financial system plays a critical role in the economy. Financial institutions and markets are at the centre of the processes that mobilise and allocate resources to investment. They also provide the liquidity needed for people and firms to be able to transact. A market economy could not work without a well-functioning financial system.

The financial system is also inherently vulnerable. It relies fundamentally on public confidence being maintained in the financial institutions and markets that make it up. That confidence is easily damaged by financial failures. Yet experience indicates that financial institutions can and do fail. In part, this stems from the fact that most financial institutions are exposed to complex and wide-ranging risks, are highly leveraged, and tend to ‘borrow short and lend long’. Occasional small failures attributable to isolated events may not do too much damage to confidence, or disrupt the operation of the system. But failures of systemically important institutions can cause significant damage to the wider economy.

The Reserve Bank’s prime responsibilities in relation to the financial system concern the supervision of registered banks. Specifically, the Bank is charged with monitoring and supervising registered banks for the purposes of promoting the soundness and efficiency of the financial system, and avoiding significant damage to the financial system that could result from the failure of a registered bank. This priority for the Reserve Bank reflects the fact that registered banks are the dominant lending institutions to both households and firms, and their deposit liabilities comprise the greatest part of the money stock used as a means of payment. Banks also provide the core mechanisms for making payments, such as EFTPOS and cheques. These roles place banks at the centre of the financial system. Hence, in our Financial Stability Reports there will always be a focus on the banking system.

In addition to this focus on banks, we envisage examining other components of the financial system as part of a wider surveillance role. That wider surveillance will include reviewing the domestic and international financial environment, with a view to identifying potential stresses and strains, as well as the various components of the financial system beyond the banks. The latter include nonbank institutions, and the financial markets, particularly the foreign exchange and bond markets.

Summary and assessment

The New Zealand financial system currently is stable and functioning effectively. This stability reflects a generally favourable macroeconomic environment, sound financial institutions, and well-functioning financial markets. The New Zealand economy has generated solid income growth for the past five years, which in turn has supported debt servicing capacities and asset values. These macroeconomic developments have underpinned the maintenance of financial stability through this period.

But there is always a risk of ‘too much of a good thing’. Experience shows that episodes of financial instability often have their origins in long economic expansions, which can lead to unsustainable optimism and downplaying of risk. Low interest rates during the last three years have led households in New Zealand — and in many other developed economies — to increase their leverage. Some households may now be in a position where an unexpected and significant increase in interest rates, or a slowing in the growth of disposable income, would result in some financial strain. That could accentuate a cyclical downturn, and make for a more difficult financial environment for both firms and households, and indirectly, the financial institutions exposed to them.

Global imbalances have also mounted, reflected in particular in a large current account deficit for the United States (US). These imbalances highlight the uncertainties that always surround exchange rates and underscore the importance of exchange rate risk management, by both firms and financial institutions, for the maintenance of financial stability.

But our current assessment is that these risks are not large. The New Zealand banking system is financially robust, and our analysis indicates that it would be resilient to a wide range of unexpected events. Banks have been very profitable, and generally have strong and well-diversified asset portfolios.

At the same time, however, the New Zealand banking system has become more concentrated. The amalgamation of the ANZ and National Banks has resulted in a single bank that accounts for a third of the banking system, and four systemically important banks that are all owned from a single country (Australia). Those four banks account for 85 per cent of the New Zealand banking system’s assets, and each is of a size, and plays such a central role in the New Zealand financial system, that closure in the event of failure would have significant adverse effects on the wider financial system and macroeconomy. This underscores the importance of policies that provide the Reserve Bank with the capacity to maintain those banks’ operations should they come under serious financial stress.

Non-bank credit institutions have also been performing strongly, and growing rapidly across a range of markets, particularly in financing property development. A slowing of the economy, and in the property market in particular, could pose some difficulties for any institutions that have been assuming greater risk in funding speculative developments or in taking on unproven business.

New Zealand’s core financial markets — the benchmark government bond market and the foreign exchange market — are small by international standards, but they have previously demonstrated a capacity to cope well with financial shocks and uncertainty. Currently, liquidity in these markets is broadly in line with that seen in recent years, suggesting ongoing resilience.